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Jahangir Aziz, global head, emerging markets economics and commodities research, JPMorgan.
Jahangir Aziz, global head, emerging markets economics and commodities research, JPMorgan.

‘One needs to provide cash now, not in some uncertain future’

Those demanding a fiscal stimulus to jump-start economy need to first get a reality check on what India can afford, says Jahangir Aziz, global head, emerging markets economics and commodities research, JPMorgan

NEW DELHI : As the economy reopens gradually, the focus of discussion is rapidly shifting to the recovery and the desired stimulus from the Union government. In an email interview, New York-based Jahangir Aziz, global head, emerging markets (EM) economics and commodities research, JPMorgan, dwelled in detail on the options before the government. Edited excerpts:

All indicators suggest the lockdown has savaged the economy.

The apocalyptic slump in manufacturing and especially services Purchasing Managers’ Index (PMI) for April are ominous signs of the unprecedented scale of growth destruction that has taken place. Even at the depths of the global financial crisis, India’s PMIs did not print such numbers. Moreover, while the lockdown is being slowly lifted in many parts of India, they are not in the red zones. These zones, unfortunately, also account for the bulk of India’s gross domestic product (GDP). What is more disconcerting is that even after six weeks of a nationwide lockdown, there is still no sign of the infection rate peaking. So, this could be a very slow grind.

There is general consensus for an enormous fiscal stimulus to jumpstart the economy.

Those demanding such stimulus need to first get a reality check on what India can afford. The government on Friday announced a new borrowing programme of 12 trillion. This is almost identical to what we were expecting. If you add even some reasonable amount of fiscal slippage from the states, the combined fiscal deficit will go up from 7% of GDP in FY20 to 11% of GDP in FY21 and then add about 2-2.5% of GDP in off-budget spending through public sector undertakings (PSUs) that this government has undertaken for the last few years, and the public sector borrowing requirement goes to 13-14% of GDP.

In our calculation, which as I said is almost identical to the announced borrowing package, we do not envisage any increase in the total budgeted spending. So all the pandemic-related spending or relief is assumed to be fully offset by spending cuts elsewhere. The rise in deficit is only because of the decline in revenue. We do not know what tax revenue the government is basing its projection on. So, if the government has in mind additional spending then the fiscal deficit will rise even more.

Now comes the rub. If the government wants to limit the deficit, the recovery will be stymied and if the government plans to borrow all this from the market, domestic or foreign, interest rates will spike to levels that will cramp the recovery.

So, without an answer to the question of how specifically we will fund just the revenue shortfall, all other discussions related to stimulus spending is moot.

Should the fiscal stimulus be strong on design or big on size?

Two factors will drive the size and nature of the stimulus: what is the size of the economic shock and what can hamstring the recovery when the economy is opened. As of now we do not have any idea of the extent of damage. So I do not even understand how people are coming up with the amount of stimulus the economy needs.

However, we do know from other crises what might be the critical constraint in the recovery: it is the impairment of household and corporate balance sheets. If households have had to use their savings or firms, especially small and medium enterprises (SMEs), have piled up large debt service obligations to survive the lockdown it will become the critical factor that cannot be offset by any amount of stimulus. More importantly, to those who are demanding more infrastructure spending, is it even feasible to believe that the budgeted infrastructure projects will be completed given the closure and likely continued social distancing policies when India opens up?

So really there is only one policy option: provide extensive income support to those households, such as migrant workers, and SMEs who hire most of them and ones who do not fall under any tax bracket through JanDhan and Mudra accounts and for the individuals and corporates whose incomes are taxable through large tax credits on last year’s (FY20) tax obligations. One needs to provide cash now. Not at some uncertain future.

How do you fund this stimulus?

The only reasonable way out is for the central banks to buy government bonds in the secondary or primary market. This is essentially quantitative easing (QE). Many countries such as India and Indonesia have been doing this for years as part of liquidity management and so it should not be a big step to scale up the purchases to fund a large part of the deficit increase. Others, such as South Africa, have been hesitant because they have not indulged in bond purchase in recent years. In Brazil and Mexico, legislative changes to central bank laws are already underway for them to buy both government and corporate bonds.

At JPMorgan we have recently undertaken a very large EM-wide exercise and have found that if these high-yielder and current-account-deficit central banks supplement QE with other measures, including changes in regulations of insurance and pension fund holdings of government assets and extend regulatory forbearance, then the average size of QE can be limited to around 3% GDP. The low-yielding and current account-surplus economies can probably get away with much larger QE of 5-6% of GDP given their low initial debt and deficits.

In the case of India, not only should the Reserve Bank of India (RBI) do QE but it also needs to directly fund the budget by buying in the primary auctions instead of letting the auctions devolve. How much QE is needed will depend on the other regulatory changes that the RBI brings about.

QE is potentially inflationary though.

Potentially lots of things can happen. India might miraculously recover all the lost output in one quarter and crude prices can go back to $100 per barrel.

The questions is what is a likely scenario. Beyond some spike in food inflation in the next few months because of the disruption to food supplies, India should be so lucky as to see inflation pick up. Because that would mean there hasn’t been any material demand destruction and all is well with the world. In this case, deficits won’t be as high and there will be no need for QE either.

Many detractors will also say that this might weaken RBI’s balance sheet. This is just a red herring; RBI is a central bank not a commercial bank. RBI can discharge all its responsibilities regarding monetary policy and bank supervision even with negative capital. RBI has about $460 billion in foreign currency reserves.

A 10% appreciation of the rupee wipes out 3.5 trillion from RBI’s capital. Do we worry about that?

There are, however, legitimate fears. That has to do with RBI losing credibility as an inflation-targeting central bank. This fear comes from the experiences of the dark days of the 1970s and 1980s when India was ravaged by low growth and high inflation as RBI funded large fiscal deficits from its balance sheet supplemented by extensive financial repression. Funding the budget from the central bank’s balance sheet is an easy option to not doing fiscal consolidation. So if this breach becomes a habit instead of a unprecedented response to an unprecedented shock, then we have cause to worry.

I am not saying that doing QE is easy. To allay such concerns, the RBI will need to provide convincing forward guidance that this breach is temporary and only intended to provide the needed time for the economy to recover. This should not be hard to do.

RBI, like other central banks, is the only entity that has a strong enough balance sheet to absorb the size of this economic shock. It needs to use it. In my view, the cost of not doing QE, warts and all, far outweighs the cost of doing it.

Another proposal suggests that the Union government should, like the corporate sector does, pledge the shares of public sector undertakings with RBI to avail of a loan. The idea is to avoid distorting yields in the money markets. Your thoughts.

How does this help? Is one really arguing that the credit risk from holding PSU equity on the RBI’s balance sheet is less than the credit risk of directly holding Indian government bonds? If not, then the implied credit risk will distort yields unless the government guarantees that credit risk, which is a contingent liability of the government, that will raise the implied debt and deficit and push up yields. There are no clever financial engineering solutions to the problem that the government needs more resources than what the private sector, domestic or foreign, have provided in the past or can feasibly provide now.

Let us not forget that funding the government is only part of what RBI has to do. Indian corporates are and will increasingly face serious challenges in servicing their debts. The current policy of RBI in pumping massive liquidity into banks hoping that the latter will on-lend these funds to corporates in need is not working. Banks do not want to take this added credit risk given how uncertain corporate earnings are at this juncture.

So sooner or later, RBI will have to provide liquidity directly to corporates as recently undertaken by the US Federal Reserve and the European Central Bank. This will mean that RBI will also have to repo corporate bonds directly on its balance sheet and take that credit risk. As I said before, RBI is the only entity that has the balance sheet to buffer the economy from such a massive shock.

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